On Sept. 9, 2019, the U.S. Treasury and IRS issued proposed regulations under IRC Section 382(h) pertaining to the interaction between built-in gains or losses with Section 382 limitations. Treasury believes the proposed regulations will simplify the application of Section 382, provide needed clarification to taxpayers in determining built-in gains and losses, and address other issues relating to Section 382 that were created as a result of tax reform (the Tax Cuts and Jobs Act of 2017). Taxpayers are not as optimistic about these recent developments, and for good reason.
If the proposed regulations become finalized as currently written, corporations will be severely limited in their ability to use net operating losses (NOLs) subject to Section 382. Section 382 has been in existence for over 30 years and was intended to deter corporations from purchasing a company with NOLs and other tax attributes for the sole reason of reducing their own taxable income. The Section 382 limitation generally equals the fair market value of the target’s equity immediately before the ownership change, multiplied by the federal long-term tax-exempt rate (the base limitation). Under Section 382(h), if the loss corporation is in a net unrealized built-in gain (NUBIG) position immediately before the ownership change, the base limitation can be increased during the initial five-year period following the ownership change (referred to as the recognition period) for the recognition of any preexisting built-in gains. Conversely, if the corporation is in a net unrealized built-in loss (NUBIL) position, any recognized built-in losses during the recognition period will be subject to the annual Section 382 limitation. Generally, the amount of the NUBIG or NUBIL equals the amount by which the aggregate fair market value of the assets is greater or lesser than the aggregate tax basis of the assets, adjusted by certain items of income or deductions.
In 2003, the IRS issued Notice 2003-65 that provided taxpayers with two safe-harbor approaches to calculating recognized built-in gains (RBIG) and recognized built-in losses (RBIL). The two safe harbors were commonly referred to as the “Section 338 approach” and the “Section 1374 approach.” The recently released proposed regulations under Section 382(h) moved to permanently eliminate the Section 338 approach.
Typically, the Section 338 approach was beneficial for companies with a NUBIG, as they were able to use hypothetical amortization and depreciation deductions (often referred to as foregone amortization) as RBIG permitting additional use of the target’s NOLs. Taxpayers who were in a NUBIL position (and already would have favored the existing Section 1374 approach) take a hit as well, with the proposed regulations adding that contingent liabilities existing immediately prior to the ownership change and subsequently deducted during the recognition period are now treated as RBIL. Both changes could significantly impact the value companies assign to NOLs and other tax attributes when determining and negotiating an acquisition’s purchase price.
The proposed regulations outline the general approach when determining a company’s NUBIG or NUBIL position as shown here:
One of the key distinctions between the Section 338 approach and the Section 1374 approach is in the measurement of RBIG and RBIL. Both approaches compute the amount of NUBIG and NUBIL similarly. However, in determining RBIG or RBIL, the Section 338 approach generally compares the actual treatment of items of income, gain, deduction, and loss by the loss corporation with the treatment of such items under a hypothetical Section 338 election with the assets hypothetically stepped up to fair market value. Thus, the hypothetical amortization or depreciation on the built-in gain assets can generate RBIG.
The Section 1374 approach does not allow for the concept of forgone amortization in the determination of RBIG or RBIL. Rather, the Section 1374 approach would require an actual disposition of the asset to recognize the built-in gain or loss on the asset. This is a significant differentiator, as taxpayers may be inclined to dispose of certain assets during the recognition period to benefit from any RBIG, potentially compelling them to dispose of such assets earlier than desired. For pharmaceutical companies and other industries that have tremendous amounts of value in self-created intangibles (with no tax basis), the above changes could result in much larger tax bills due to the inability to offset a target’s built-in gains with the target’s preexisting NOLs. This creates a perceived mismatch of the target’s income and losses, and seems to go against the neutrality principle underlying the spirit of Section 382.
The Section 1374 approach as written in the proposed regulations generally resembles how it was originally written in Notice 2003-65, but there are some key differences that Treasury believes will improve computational accuracy:
- Excluding the amount of recourse liabilities in excess of fair market value of a company’s assets for determining NUBIG/NUBIL
- Linking contingent liabilities to the amounts reflected in taxpayer’s applicable financial statements
- All deductions (even if contingent) are treated as RBIL during the recognition period
- Cancellation of debt income on recourse liabilities during the 12- month period is generally treated as RBIG
- All bad-debt deductions are treated as RBIL during the full five-year recognition period
- Hypothetical cost-recovery deduction methodology has been adopted for calculating RBIL
- Excludes income from wasting assets, income from license or leasing property, prepaid income, dividends, Subpart F income, and Section 951A global intangible low-taxed income
There are other provisions found within the Section 382(h) proposed regulations specifically addressing the interaction of Section 382 with the newly revamped Section 163(j) and disallowed interest expense carryovers.
While concerning, these proposed regulations are just that – proposed. They are set to be effective for ownership changes occurring after the date the regulations become finalized, but taxpayers are already requesting that a binding contract exception be added. In the meantime, taxpayers may continue to rely on Notice 2003-65 and apply either the Section 338 approach or the Section 1374 approach. However, if the last two years are any indication of the urgent pace in which Treasury is releasing final regulations in response to tax reform, anticipate that these regulations will become finalized – perhaps with some variation – in the near future.
Practitioners had until Nov. 12, 2019, to provide comments on the proposed regulations, which further indicates a possible accelerated turnaround time to finalization.
James P. Swanick, CPA, is managing director with Global Tax Management Inc. in its Wayne office and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
Michael J. Tighe, CPA, is a senior tax manager with Global Tax Management Inc. in Wayne and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.